Prominent writers and investors have described today’s economy as addicted to loose monetary policy, particularly of the QE variety. That could be something similar. After all, the Fed has just begun tapering, and some of the economy’s withdrawal symptoms are acute. Things are especially interesting, or troubling, when we look at how intertwined monetary and fiscal policy have become.
For example, the Fed’s current holdings of Treasuries are more than double their pre-World War II high. The accompanying chart shows federal debt to the public as a percentage of GDP, broken down into Federal Reserve debt and non-Fed public debt, with the most recent data since 1940. As the top line of the chart shows, total public debt has grown rapidly since 2001 and now exceeds 100% of GDP.
As for the Fed’s share, it exceeded 10% during World War II, yet in the post-WWII period, Fed holdings ranged from 5% to 6% per year until 2010. Then, in a clear break from the trend, the second half of 2009 saw quantitative easing used for outright purchases of medium and long-term US Treasuries. As a result, the chart shows, the Fed’s holdings more than doubled in 2011 and have historically risen above 10% of GDP for all years through 2019. In 2020, the Fed’s share will more than double the second During the most recent data available, in 2021, the Fed’s share of GDP reached 24.3%, surpassing its peak of 10.4% during WWII.
The chart may also understate the Fed’s public debt holdings when looking more closely at medium- and long-term Treasuries. As of December 2021, the Fed owned 38% of 10-30 year bonds, according to the New York Federal Reserve’s May 2022 report on open market operations. From this point forward, there is a long way to return to roughly pre-pandemic levels.
Some economists say a ballooning Fed balance sheet is nothing to worry about, and the Fed itself has promised to sterilize the kiwi from affecting bank reserves. However, George Selgin, John Cochrane, James Dorn, and others have argued that too high a Fed’s holdings of government debt compromises the central bank’s independence in times of inflationary risk. Today’s inflation is caused in part by the historic expansion of the money supply needed to finance Washington’s spending spree. St. Louis Fed economist Fernando M. As Martin points out (see Money and Deficits figure), the growth rate of M2 since 2016 has closely tracked the growth rate of the budget deficit. Even the floor system for paying interest on excess reserves (IOER) faces exposure. As Thomas Hogan recently argued on EconLib, the Fed could have met its unemployment target by doing less QE during the Great Recession, if it had decided to lower the IOER.
Now, after nearly a generation of holding interest rates down, a shift to quantitative tightening combined with rising yields will strain the federal budget. As we have recently shown, net interest will exceed 10% of the budget within the next five years. The fiscal pain of falling from 24.3% of GDP may be too much to bear, prompting fiscal policymakers to press the Fed again. Can Congress depart from the Fed’s easy money policy that has allowed them to push debt levels above 100% of GDP, or will addiction demand more QE to support Washington’s spending habits?
Peter Calcagno is professor of economics at the College of Charleston and director of the Center for Public Choice and Market Process. Public Choice and Public Policy Project Fellow with AIER. He has served as treasurer of the Public Choice Society, voting member of AIER, board member of Classical Liberals of the Carolinas, and on the board of APEE. His research areas are applied microeconomics, public choice and political economy. He is the author, and editor, of dozens of journal articles and book chapters Unleashing Capitalism: A Prescription for Economic Prosperity in South Carolina.
Edward J. Lopez is professor of economics, BB&T Distinguished Professor of Capitalism, and founding director of the Center for the Study of Free Enterprise at Western Carolina University. He is Executive Director and Past President of the Public Choice Society, Past President of the Private Enterprise Education Association, and Associate Editor of The. Journal of Entrepreneurship and Public Policy. In 2008-09 he was a Liberty Fund Scholar in Residence.